China's TARP?

Conclusion: Rumors suggest China is on the verge of introducing a major bailout package for its reportedly ailing Local Government Financing Vehicles. Analysis of these loans, the Chinese banking industry, historical precedent, and recent moves throughout Chinese financial markets suggest at least some level of caution is warranted.

Over the last week, credit quality in China has once again been making (or at least trying to make) headline news. Per Reuters and a bevy of secondary reports, the latest unconfirmed speculation out of mainland China is that the central government is preparing to shift 2-3 trillion yuan of recently-extended debt off of local government balance sheets. The amount, equivalent to $309-$463 billion, is roughly 14-21% of the total outstanding debt of China’s Local Government Financing Vehicles (LGFVs) according to the PBOC’s 2010 Regional Financial Operations Report.

At an amount roughly equivalent to 5.2%-7.9% of China’s GDP, it’s clear to us that this bailout of sorts is a big deal. To put some context around the size of this rumored bailout package, TARP was “only” 4.9% of US GDP at the time of passage. Whether or not this winds up being “it” as it relates to financial crisis aversion in China remains to be seen.

One thing that is quite disconcerting is the strong denial of any bailout by Chinese officials. Wu Xiaoling, vice chairman of the National People’s Congress Financial Committee dismissed the rumors yesterday, saying that they had been confused with a telegraphed government investigation into LGFVs during the June-September period. As we have learned from the likes of Greece, Ireland, and the US for that matter, politicians’ denials of market rumors are typically anything but a sign of relief.

That said, we are in the unique position of waiting for more data before we jump ship on our Year of the Chinese Bull Thesis. As mentioned in our previous work on China, we’ve chosen to remain on the sidelines here, rather than expressing this idea in our Virtual Portfolio due to China-specific quantitative factors (Shanghai Composite broken TRADE & TREND) and broader Global Macro factors (our 27-factor risk management model continues to signal to us that equities should be underweight as an asset class within our Dynamic Asset Allocation Model). Separating research ideas from actual investments remains one of the hallmarks of modern-day risk management, as well as one of the best ways to practice Warren Buffet’s rule #1: don’t lose money.

Shifting back to the Chinese bailout rumor specifically, let us dig into the background story and relevant components in an effort to get you up to speed.

In an unprecedented effort to avert a sharp recession for the Chinese economy, the central government via Chinese financial institutions oversaw a 17.6 trillion yuan ($2.7 trillion) expansion of credit from 2009-2010. During the rapid debt buildup, money supply (M2) growth peaked at +29.7% YoY in November ’09. It has since come down to more trend-line levels as the central bank ramped up its efforts to drain liquidity and curb property speculation over the last 18 months via a cumulative +550bps increase in bank reserve requirements, as well as four interest rate hikes since October ’10 totaling +100bps.

A great deal of the credit expansion over the last two years had been funneled through the aforementioned LGFVs. For background, current statutes in China prevent local governments from issuing debt to finance spending and investment; as a result, they have setup alternate arms-length entities through which debt financing is procured. It can be strongly argued that their obligation to implement the central government’s stimulus objectives over the last couple of years is perhaps what got them into the current situation. Moreover, as the Jim Chanos-es of the world would have you believe, rapid and perhaps reckless credit expansion is not without consequence.

According to the PBOC’s recent report, the total number of LGFVs grew +25% from 2008-2010 to over 10,000 and their collective debt burdens grew +50% in 2009 and +20% in 2010 to an estimated sum of 14 trillion yuan ($2.2 trillion) or 28% of total credit outstanding throughout the Chinese banking system as of April. Additionally, Premier Wen Jiabao’s push to build 36 million low-income housing units is estimated by some analysts to add another 1.9 trillion yuan ($296 billion) to the existing LGFV debt burden in this year alone and another 4.9 trillion yuan ($757 billion) through 2015.

Further, the PBOC profiles these loans as “mostly long term” and “linked to infrastructure projects” with about half of them coming due in 2014-15. An unverified leak from an unnamed Chinese official suggests that roughly 20% of the total LGFV debt burden would ultimately wind up in the non-performing loan category; Fitch Ratings assigns a 30% NPL rate in their worst-case scenario.

Using the aforementioned 20% or 30% NPL rate, that roughly equates to the Chinese banks having to charge-off 5.6%-8.4% of their total loan books over the long term, with roughly half of that occurring in the next 3-4 years based on the maturity schedule of the aggregate LGFV debt burden. That’s a pretty substantial amount of bad loans that will likely have to incrementally reserved for – which is perhaps why Chinese banks have been substantially underperforming the broader index of late.

Last year, Chinese banks sold a combined $70 billion of shares in a comprehensive effort which included cutting dividend payout ratios (an average of -200bps to 37% for the five largest banks) and expanding non-lending businesses to become compliant with higher capital requirements. Back in April, China’s banking regulator drafted rules forcing banks to have Tier 1 capital ratios of at least 8.5% by 2016; for reference, the nation’s lenders had an average Tier 1 capital ratio of 10.1% according to the same documents (that compares to an average of 12.3% of the world’s top 100 largest banks by market cap, per Bloomberg). Still, the rules assume average credit expansion to the tune of +15% YoY alongside economic growth of +8% YoY per year, which implies Chinese banks are likely to have to add another 1.26 trillion yuan ($195 billion) in supplementary capital over the next five years.

From a more immediate perspective, the same regulator has forced the nation’s five largest banks (combined holders of 26.8 trillion yuan of risk-weighted assets) to adhere to a minimum capital adequacy ratio of 11.5% throughout 2011. Should any of them fall below that threshold for any moment of time, they’ll be forced to raise capital, slow loan growth, delay acquisitions, and/or suspend new branch openings to become compliant in 90 days. As the chart below shows, each of the banks is well capitalized above the recently-implemented floor, but still well below the average capital adequacy ratio of the world’s 100 largest banks by market capitalization, per Bloomberg.

All told, it’s too early to tell whether or not China will actually implement drastic measures to avert or mitigate any potential credit crisis surrounding LGFV debt over the long term. History shows there is precedent for the Chinese government to undertake major intervention initiatives, having spent roughly $650 billion bailing out its banks from 1. Recent moves in China’s sovereign CDS and select bank CDS do, however, suggest that at least some level of incremental caution regarding China’s banking sector is merited.

At the bare minimum, we find that “doing nothing” is the best immediate-term plan of attack here. Waiting and watching from the sidelines will afford us a more objective interpretation of the data as it rolls in. Additionally, it’s important to keep in mind that we are potentially in the early days of a multi-year developing story, so there’s no sense in rushing for answers, as any you are likely to receive now may wind up far from the realities of tomorrow.

Unless of course you’ve have an “unnamed” Chinese bureaucrat on speed-dial.

Darius Dale

Analyst

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06/09/11 11:25 AM EDT

CAKE - UPDATING INFLATION EXPECTATIONS

With the volatility in the commodity elevated and corn hitting record highs today the comments from CAKE management team highlight the risk to EPS this year. I know they can’t update guidance weekly given the volatility in the commodity markets, but we can. Coming into this year CAKE had 60% of their costs contracted for, leaving the balance to float for the balance of the year.

As of the last update in April, they talked about 3.5% food cost inflation for the year. The trends would be heavier in the first half (4.5%), which what it was in 1Q and looks like it will in 2Q, but falling to around 2.5% in the second half of the year. The reason for the slower rate of change in 4Q primarily because 4Q10 had very high dairy prices last year and dairy is a commodity that is not contracted for.

CAKE is not expecting commodity costs to fall off a lot, rather as management stated today, “we're just not expecting them to be at the economically high levels that they were in the fourth quarter last year particularly with respect to the dairy component.”

As the charts below illustrate, dairy costs are currently higher than they were in 4Q10. Of course, there has been significant volatility of late and there is potential for a snap-back. However, management may be forced to revise its expectations with respect to the dairy component of food costs if prices in cheese and milk markets remain anywhere close to where they are currently trending. While there is still time for management to revise its view, we are watching this closely.

Howard Penney

Managing Director

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06/09/11 10:41 AM EDT

HEDGEYE MACRO & FINANCIALS: WHAT'S NEXT FOR THE FED?: DIAL IN & MATERIALS

JOBLESS CLAIMS: EXPECT A ROUGH SPOT AHEAD

We are hosting a call this morning at 11 am with the Hedgeye Macro Team:

"MACRO & FINANCIALS: WHAT'S NEXT FOR THE FED?"

Contact us for access to the slide deck

Dial-in:

Code: 848675#

End of QE2 Presents Risks for Claims

At the end of QE1, claims stopped going down. When QE2 began, claims started falling again. While this model may be simplistic, it's shown to be effective over the last two years, as the chart below shows. When the Fed has the spigots on, the market has climbed and claims have dropped. In the drought between QE1 and QE2, claims tread water. We have been watching the charts below for several weeks with a sense of unease, and we expect that the end of QE2 in a few weeks will present another choppy period for claims.

Claims Rise 5k

Initial Claims rose 5k to 427k last week (+1k against the upwardly-revised print from last week). The 4-week rolling average dropped slightly, falling 3k to 424k. According to our model, claims must drop into the 375-400k range before unemployment can begin to improve.

2-10 Spread

We track the 2-10 spread as a proxy for NIM. Thus far the spread in 2Q is tracking 11 bps tighter than in 1Q. This week's spread level of 257 bps compares to 250 bps last week.

Financials Subsector Performance

The chart below shows the price performance of subsectors over four durations.

Joshua Steiner, CFA

Allison Kaptur

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06/09/11 08:32 AM EDT

TALES OF THE TAPE: MCD, CPKI, BOBE, DRI, BWLD, DIN, TXRH, KONA

Notable news items and price action from the restaurant space as well as our fundamental view on select names.

MCD traded flat yesterday despite weaker than expected May sales results being released yesterday before market open. Our view is that May’s results offer further evidence that the core business is waning and comps are being driven by beverages. Europe’s soft performance is a focus for many as the E Coli situation continues on the continent with a potential negative impact for MCD’s June sales causing concern.

CPKI and Golden Gate Capital today announced that CPK Merger Sub Inc. has commenced the previously-announced tender offer for all of the outstanding shares of common stock of the Company at a price of $18.50 per share, according to a press release published by the company yesterday.

THE M3: HODW; SHOPPES AT MBS; JUNKETS

The Macau Metro Monitor, June 9, 2011

DANCING WATER TURNING A PROFIT Macau Daily Times

Sunny Yu, MPEL's VP for entertainment and projects, said The House of Dancing Water (HODW) so far has received over 500,000 spectators and that the attendance rate is still above 90%. Yu confimed HODW's revenue is covering all operating expenses. "If it continues doing great, within 10 years we will get our investment back," said Yu.

LVS COO Michael Leven said, "We did over a billion dollars in our first year in EBITDA (for MBS). We expect that to grow. I think a four-to-five year payback in that situation, anybody would be happy with that return on investment. We should do that very easily without even selling an asset like our mall (The Shoppes at MBS), which we expect to sell maybe in 2013 or 2014, which can provide as much as US$4 billion back for our $6 billion investment just on the mall alone."

The Shoppes now has more than 250 stores and restaurants. The Shoppes has been facing complaints of slow traffic from some retailers.

NO GOLDMINE Macau Daily Times

Samuel Tsang, the Century Legend Group chairman, said most investors don’t understand the risks of running a junket. He stressed the percentage of the bets paid back to VIP gamblers is increasing to an average of 1%. Meanwhile, the former executive vice president of Sands China, Luís Mesquita de Melo, wants more transparency and supervision of junkets. "The regulations somehow dilute the responsibility between junkets and operators, which allows for a lot of sub-junkets that don’t go through the licensing process...politicians need to discuss and decide if it makes sense to allow junkets to remain a subculture or if they should bring them into the gaming business," he remarked.

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